Power companies deliver solid returns

Recommendations by industry bodies currently being considered could reduce peak demand and in turn the need for costly investments in transmission. Photo: Glenn Hunt

Angela Macdonald-Smith

Just as they are on the Monopoly board,electricity and gas networks are solid investments, and particularly when markets turn shaky.

The sturdy yields and relatively low risks to be found in the regulated utility sector have made stocks such as Duet Group and Spark Infrastructure popular in the current uncertain economic environment.

But over the past few months, the political and regulatory risks have heightened as household power bills have hit the headlines, the finger being pointed at unnecessary spending by some network and transmission line owners.

Regulators are wielding more power in key decisions that may translate into weaker returns in the medium term, and forecasts for power demand have been wound back.

But if that has made investors pull back from the sector, some experts believe they may want to think again, pointing out that even if some rules are toughened up, it won’t significantly alter the investment fundamentals.

“We believe regulation risk is overblown in the sector,” says RBC Capital Markets utilities analyst Paul Johnston, who points out that the over-spending problem is an issue for some government-owned companies rather than the listed operators.

“The rules will remain supportive for the sector for investment and for returns,” he says.

The utilities sector was a star performer in the 2012 financial year as market confidence waned, the benchmark utilities index growing 11 per cent, against an 11 per cent dip in the broader ASX 200 Index.

The stocks typically provide attractive yields, of about 7-9 per cent, which are regarded as sustainable given moves by the companies over recent years to cut debt. Growth is also on offer because of the billions of dollars needed to upgrade infrastructure which, through the regulatory process, increases the value of the companies’ assets and results in higher revenues, supporting returns.

Patersons economist Tony Farnham also believes the sector has further to run, despite its popularity over the past year, alongside fellow defensively oriented sectors such as telecoms, consumer staples and healthcare, typically all high dividend payers.

“At this point in time, the cyclical sectors as a group are a bit of a road too hard to travel and, as a result, it’s a better option to go into defensive sectors,” Farnham says.

He cites the degree of “price inelasticity” of power and other utility product prices, which is relevant even amid weak power demand growth.

Forecasts of growth in electricity use have been downgraded over recent months, partly owing to reduced manufacturing in energy-intensive sectors such as aluminium, but also because of energy saving by customers and increased use of solar panels. Demand across the national electricity market fell 2.4 per cent in 2011-12 and is expected to be flat this year. Consumption may not reach its 2009 peak again until 2014 or 2015, according to the Australian Energy Market Operator.

But peak demand, which is more important for the transmitters and distributors, is still growing in many states. Regulated network owners are also protected from the full effects of weak demand because of the way their revenues are set, by regulators in five-year periods.

Analysts differentiate between those companies that produce and sell electricity and gas, and those that own the infrastructure to transmit and distribute the energy.

For retailers such as Origin Energy, AGL Energy and unlisted TRUenergy, the risks are higher owing to intense competition in some states and moves by regulators and governments in others, such as Queensland, to slap freezes on retail prices or impose other rules that crimp returns.

But network utilities – Duet, Spark, Envestra and SP AusNet, as well as APA Group in part – are protected by relatively generous national rules that are more difficult to change, offering some insulation for earnings and therefore dividends.

Confusing and concerning for investors, however, are the multiple reviews under way by a range of regulators and commissions, which influence the climate for companies whose pipelines and power lines have monopoly positions.

Of particular concern recently were Australian Energy Market Commission proposed changes to national energy regulations. This is the body that sets the rules that the Australian Energy Regulator implements.

A number of the proposals will hand more flexibility to the AER in setting revenues for utility networks, giving it more discretion to assess capital expenditure, operating costs, the value of assets and the cost of capital.

Moody’s has warned the changes will mean the network owners can no longer rely on predictable and stable decision-making by the regulator. It says prescriptive methods of calculating key measures such as the cost of debt and allowable capital expenditure will be replaced by an approach in which the regulator can exercise more discretion.

“Moody’s believes that the overall credit implications of the draft rule changes are likely to be negative,” it says, although adding it does not expect to downgrade any ratings as a result.

But analysts say the proposed changes stop well short of what the AER had been looking for. Crucially the AEMC has not handed the AER the unfettered power it sought to decide on capital expenditure and operating costs, rather the onus remains on the regulator to prove why spending proposed by a company is unreasonable.

Yet with the increased discretion to be handed to the AER, the outcome of an ongoing review into the key process to appeal a decision by that regulator is seen as important.

Other processes under way, including a Senate Committee probe into the cause of power price rises and a Productivity Commission review of electricity network regulation, may also throw up decisions that will affect the sector.

Meanwhile, the AEMC is due to issue recommendations this week into “demand-side participation”, which are expected to enable large electricity users to better manage the cost of their consumption. Some of those proposals may materially reduce peak demand, lowering the need for costly investments in transmission, according to Energy Efficiency Council chief executive Rob Murray-Leach.

UBS analyst David Leitch says it all adds up to a push-back to the current phase of “aggressive” investment by network and transmission companies, which will affect all owners, not just state-owned ones in NSW and Queensland that are perceived to be at the heart of the problem.

“The pressure on the system to manage down the growth in network assets and prices has increased a lot,” he says, while acknowledging it will take time to flow through into lower returns for regulated asset owners.

Spark, for example, is safe from any changes to the regulatory regime for its assets until mid-2015 at the earliest.

Leaving aside regulation, all four listed network owners have taken action to simplify their corporate structures, streamline their portfolios and reduce debt since the global financial crisis, when they also peaked in popularity among investors.

Lowering gearing and cutting distributions have eased concerns about the capacity of their cash flows to fund investment in expansion projects and cover dividends.

In particular, Envestra is widely regarded as well placed to increase its dividend payments, even with a key Victorian regulatory decision due later this month. An upgrade in its Standard & Poor’s credit rating this coming year, to BBB from BBB-, could also be on the cards, according to UBS.

Dividend yields from the sector in general remain attractive, particularly compared to yields on government bonds, which are near 60-year lows. The premium offered by some of these stocks over 10-year government bonds has reached about 4 per cent, which RBC’s Johnston says is “a high premium to receive for what are very low risk investments, with growth as well”.

SP AusNet, the least favoured stock in the sector by many analysts because of the risk of bushfire-related litigation, has also recently had a share of the good news. A draft AER ruling suggests it will be able to recover any shortfall in its insurance cover arising from the Victorian bushfires through regulated revenue.

In all, this adds up to an unexciting yet relatively safe sector for investors, particularly when others are looking vulnerable.

“Investors would much rather have a regulated return than be exposed to Harvey Norman or an iron ore company right this second,” UBS’s Leitch says.

“It’s a lot easier earning a return when it’s guaranteed. It might not be a very big return but it’s nice to know it’s going to be there.”

The Australian Financial Review

BY Angela Macdonald-Smith

Angela is chief of staff, energy and utilities, based in our Sydney newsroom.